Here at GuruFocus, we talk a lot about investing within your own circle of competence. But how do you know that you really understand a stock? A good measure of knowledge is the ability to explain your subject clearly and concisely to even the most uninformed person in a brief monologue. These little speeches are sometimes called elevator pitches -- Peter Lynch called them "Two-Minute Drills." In his book, "One Up On Wall Street," he explained the topics that you will need to address for different types of companies.
Slow-growing companies
Lynch said that the most important thing about slow growers is their dividends -- the yield, payout history and whether it has the free cash flow to support future payouts. Your monologue therefore might look something like this:
“This company has increased earnings every year for the last ten, it offers an attractive yield; it’s never reduced or suspended a dividend, and in fact it’s raised the dividend during good times and bad, including the last three recessions. It’s a telephone utility, and the new cellular operations may add a substantial kicker to the growth rate.”
Cyclical companies
For cyclicals, the important factors are things like business conditions, inventories, commodity prices and prevailing trends. If you were talking about an auto manufacturer, you might say something along these lines:
“There has been a three-year business slump in the auto industry, but this year things have turned around. I know that because car sales are up across the board for the first time in recent memory. I notice that GM’s new models are selling well, and in the last eighteen months the company has closed five inefficient plants, cut twenty percent off labor costs, and earnings are about to turn sharply higher.”
Asset plays
If you are investing in a bargain stock based purely on your assessment of the value of its assets, you will want to focus on why you are getting a dollar of value for below cost price:
“The stock sells for $8, but the videocassette division [the book is from 1989] alone is worth $4 a share and the real estate is worth $7. That’s a bargain in itself, and I’m getting the rest of the company for a minus $3. Insiders are buying, and the company has steady earnings, and there’s no debt to speak of.”
Turnarounds
The key to investing in turnarounds is figuring out the approximate bottom of a stock, and pinpointing when its fortunes are about to reverse. You should focus on how the business has changed over the relevant time period:
“General Mills has made great progress in curing its diworseification [the process of adding assets that worsen the risk/return ratio]. It’s gone from eleven basic businesses to two.By selling off Eddie Bauer, Talbot’s, Kenner, and Parker Brothers and getting top dollar for these excellent companies, General Mills has returned to doing what it does best: restaurants and packaged foods.The company has been buying back millions of its shares.”
Industry stalwarts
When it comes to established names, Lynch looks at the price-earnings ratio, historical stock price levels and whether anything can happen that will accelerate the current growth rate. In other words, he looks for factors that either signify historical cheapness, or things that can make an already great business better:
“Coca-Cola is selling at the low end of its p/e range. The stock hasn’t gone anywhere for two years. The company has improved itself in several ways. It sold half its interest in Columbia Pictures to the public. Diet drinks have sped up the growth rate dramatically. Last year the Japanese drank 36 percent more Cokes than they did the year before, and the Spanish upped their consumption by 26 percent. That’s phenomenal progress. Foreign sales are excellent in general. Because of these factors, Coca-Cola may do better than people think.”
Fast growers
Investors in rapidly-growing companies look for evidence that growth and can continue at a comparable rate, and the the business model can scale effectively. Lynch also liked to consider whether the market for the business is saturated, or whether there is room to grow:
“La Quinta is a motel chain that started out in Texas. It was very profitable there. The company successfully duplicated its successful formula in Arkansas and Louisiana. Last year it added 20 percent more motel units than the year before. Earnings have increased every quarter. The company plans rapid future expansion. The debt is not excessive. Motels are a low-growth industry, and very competitive, but La Quinta has found something of a niche. It has a long way to go before it has saturated the market.”
Summary
If you know your industry and investments well, you should have no problem answering these questions and coming up with similar easy-to-understand explainers. If not, then you probably need to do some more research. Walking blindly into an investment is a sure-fire way to lose money.
Disclosure: The author owns no stocks mentioned.
Read more here:Ă‚
Warren Buffett: What I Learned From Charlie MungerÂ
WeWork: A Study in Creative AccountingÂ
Peter Lynch: Do I Have the Personal Qualities It Takes to Succeed?Ă‚
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